UK regulators recognise the benefits of distributed ledger technology and supporting innovation balanced against the need for greater investor protection in respect of cryptoassets. The Cryptoassets Taskforce has identified a number of regulatory questions which require further consultation and guidance in order to meet this need. It also calls for greater international coordination and asserts its ambition for the UK to be the global leader for DLT innovation going forward.

Support for DLT but concerns re crypto

The UK Cryptoassets Taskforce - comprising the Financial Conduct Authority, Bank of England and HM Treasury - has published its final report on the UK’s approach to the regulation of cryptoassets and DLT in financial services.

The Taskforce carried out a fact-finding exercise in relation to DLT and cryptoassets consulting with a range of stakeholders across various sectors. It concluded that DLT has the potential to deliver significant benefits in the financial services sector. However, it considers that the technology is still in its early stages and there are some significant challenges to wider adoption.

Furthermore, the Taskforces recognises that it is often difficult to determine whether cryptoassets fall within the regulatory perimeter, and that there is limited evidence of the current generation of cryptos delivering benefits.

First things first - what is regulated and what is not?

In the simplest terms the report’s analysis suggests that in the UK:

utility tokens are, in general, not regulated;

exchange tokens may be regulated already; and

security tokens are already regulated.

However, it is important to note that the report makes it clear that the regulatory perimeter depends not just on the characteristics of the token (in simplified terms whether it is an exchange, utility or security token (see our table below for details of the distinctions) but also what the use the token is put to (i.e. whether as means of exchange, capital raising or investment).

The Taskforce recommends that further consultation and guidance is needed to confirm the regulatory status of all tokens.

What should be regulated?

The Taskforce is clear that regulatory analysis of cryptoassets should be undertaken on a case-by-case basis and that any particular cryptoasset could fall under a number of categories. However from the analysis provided in the report we can draw some broad conclusions of the regulators' view of where additional regulation or guidance may be required:

Type of token

Are they regulated?

Regulators' view - should they be regulated?

Utility token: Provides access to a specific application service, but only accepted by the issuer

No - tokens of this type do not normally have the characteristics of a regulated investment/instrument

Potentially in the situation where utility tokens are structured in certain ways as to be considered emoney e.g. when centrally issued and accepted by parties as a means of exchange.

Exchange token: Provide a means of payment, but holders have no claim on the issuer, nor any rights or access in respect of the issuer

Yes - if they involve regulated payments services or meet the definition of emoney

No - if fiat funds are not involved – they aren’t a regulated investment/instrument

While they are intended for payment/exchange, some are being treated as investments by holders. Consultations in 2019 may result in regulation being extended address this risk.

Security token: Provides rights such as ownership (of the issuer or an asset), repayment of a sum of money, or entitlement to share in future profits

Yes - if the underlying asset is already regulated or if the token has the characteristics of a regulated investment/ instrument (e.g. of a share, bond, unit, etc)

Regulated as a “specified investment” under the FSMA Regulated Activities Order

The novelty of some tokens may mean that market participants do not correctly understand the scope of current regulation.

However, security tokens with the specific characteristics listed are clearly caught by current regulation, and further guidance to clarify is required.

Cryptoasset terminology

While these conclusions as to the regulatory status of these three categories of tokens will come as no surprise to most market participants, it is still the case that there is no global consensus as to what each of the categories of cryptoasset actually covers.

It is interesting to note that a recent EU report by the Stakeholder group to ESMA provided a different taxonomy based on the Swiss FINMA distinction between payment tokens, utility tokens, asset tokens and hybrid tokens (with elements of the other categories) and that their concept of an asset token is wider than just a security token covering “tokens that enable physical assets to be traded on the blockchain”.

Specific observations re cryptoassets

The Taskforce confirmed that cryptoassets are not widely used as a means of exchange in the UK, cryptoasset ownership is between 5 and 10% in the UK whilst capital raising by entities in the UK (ICOs) accounts for less than 1% of the $24 billion globally raised by ICOs.

However, interest and activity in cryptoassets in the UK has grown over the past few years. The taskforce sees the main potential benefit of crypto as the potential to use ICOs a capital raising tool.

However, it identified a range of specific risks to consumers (who may face large losses), to market integrity (through manipulation and other market abuse), in respect of financial crime and potential implications for financial stability and attempts to address those specific risks in its proposals.

Policing actions in respect of unregulated cryptos

As well as expressing the intent to form bright-line tests for the regulation of cryptoassets, there are also some soft signals that the FCA will use its high-level powers (e.g. the Principles) to, if appropriate, police actions taken by regulated firms in respect of unregulated cryptoassets.

This includes a suggestion that regulated firms should clarify if cryptoassets are unregulated when marketing them.

Possible gold-plating of AMLD5

The report notes that, in addition to the implementation of EU 5th Anti-Money Laundering Directive, the government will consult on potentially going beyond its requirements, notably by capturing peer-to-peer exchanges, cryptoasset ATMs, non-custodian wallet providers and exchange services between cryptoassets (preventing “layering”).

Interestingly, the government will also consult on potentially extending the scope of AML/KYC requirements so as to capture overseas firms that provide services to UK consumers.

Proposed consultations and guidance

The Taskforce recommends that “strong action” should be taken to address the risks associated with cryptoassets that fall within the existing regulatory framework and that specific consultations be undertaken in respect of cryptoassets that have comparable features to specified investments, but which are not currently regulated. These consultations will be undertaken by the FCA, Prudential Regulatory Authority and HMT and in summary will cover:

preventing financial crime by broadening the scope of anti-money laundering and counter terrorist financing regulations as they apply to cryptoassets in one of the most comprehensive responses globally to the use of cryptoassets for illicit activity;

a potential prohibition of the sale to retail consumers of certain cryptoasset derivatives

guidance clarifying how certain cryptoassets currently fall within the regulatory perimeter; and

whether the regulatory perimeter needs to be extended to capture other cryptoassets.

Specifically, the Taskforce recommends the following next steps and timetable:

Taskforce response to perceived risks

Next steps

Timing

Clarifying regulation of security tokens

Current regulatory perimeter not always understood or applied correctly

FCA to consult on guidance for cryptoasset activities currently within regulatory perimeter

FCA will consult on potential prohibitions on sale to retail customers

By end of 2018

Extending regulatory perimeter to cover all securities

Risk that cryptoassets with comparable features to be specified investments being structured in a way that avoids regulation

Treasury to consult on potential changes to the regulatory perimeter

In early 2019

Addressing risks of exchange tokens as investments

Exchange tokens often used for investment purposes but not caught by existing financial regulatory framework, exposing consumer to inappropriate levels of risk

Treasury to explore how exchange tokens might be regulated if necessary

In early 2019

Taxation

Tax was outside of the Taskforce’s remit HMRC continues to consider tax issues including tax avoidance and evasion

HMRC to issue revised guidance on tax treatment of cryptoassets

By early 2019

Preventing financial crime

Risks of cryptoassets being used for illicit activity increasing. Governing developing “one of the most comprehensive responses globally” to use of cryptoassets for illicit activity

Treasury to transpose the AMLD5 and broaden the scope of AML/Counter Terrorist Financing regulation further

2019

Promoting a coordinated international approach

UK authorities will continue involvement in international efforts and be a thought leader in shaping future regulation

UK will continue to engage internationally through a range of fora

Ongoing

Improving consumer awareness

Consumers should approach purchasing cryptoassets with a high degree of caution and be prepared to lose money

Authorities to take action to warn consumers

Ongoing

Maintaining financial stability

Currently, no material threat to financial stability, but risks could emerge.

BofE will continue to monitor the market. Prudential Regulatory Authority assessing adequacy of prudential regulatory framework, in coordination with international counterparts

Ongoing

Wider adoption of DLT

Beyond the immediate focus on crypto and the regulatory perimeter the Taskforce report goes out its way to focus on broader, enterprise based DLT applications and the UKs position as a leader in this space (with the “second largest” number of DLT start-ups in the world”).

Whilst the Taskforce identities a number of potential barriers to the wider adoption of DLT (technical, legal and practical) it does not perceive any specific regulatory barriers. In fact it sees “regulation as an enabler of positive innovation based on new technologies”.

In announcing each of the three individual authorities continued support of for the development of DLT, the Taskforce points to DLT’s “significant benefits” (resilience, efficiency and greater automation) and evidences a clear intention for the UK to be a global “thought leader in shaping future regulatory approaches”. At present the FCA has concluded that no changes to regulation are required to support innovation in DLT and that in particular the UK regulatory approach is “well suited to support the development of DLT in financial services”.

Supporting innovation with DLT

The Taskforce also strongly advocates supporting innovation with DLT by continuing to develop experience with DLT applications and to explore the use of DLT in:

real time gross settlement services with the Bank of England looking to ensure its new RTGS service will be capable of interfacing with innovative/DLT payment platforms;

regulatory reporting through the work being done on this by the FCA;

supporting new forms of financial services infrastructure, including work on Shared Platforms; and

the public sector including through the government Blockchain Network, the GovTech Catalyst Fund and building proofs of concept to trial the use of the technology.

What happens next?

Given the fast-moving pace of developing technology and the evolving nature of cryptoassets the UK authorities propose to keep their approach to cryptoasset and DL under review and shall convene every 6 months to consider developments and review the UK’s approach.